All eyes on ECB ..... all except ours, maybe.

Thursday 3rd December 2015

All eyes on ECB ..... all except ours, maybe.

Ref : "Deflation remains the base case but a little insurance won't hurt", INSIGHT by John Authers in the Financial Times, p.32

The markets are hanging on today's monetary policy decision by the European Central Bank with baited breath, as well they might ..... this is indeed a big deal. But since the odds are that by the time most of you read this, ECB boss Mario Draghi will have already announced that decision, we'll forego the temptation to make any predictions that may already have been proved to be wide of the mark. Suffice to say, it is almost inconceivable that the ECB won't implement further easing and will probably both lower the deposit rate (from -0.2%) and expand / extend its QE programme (from 60bn  euros per month until Sept 2016). Given how markets have been moving in anticipation of this moment, anything less than decisive action may come as a disappointment.

As it happens, our focus today is not entirely unrelated. Just about the biggest driver behind monetary easing worldwide has been inflation, or rather the alarming lack of it. In fact, if you had to pick one keyword that best sums up financial markets in 2015 it should probably be "Deflation". As Mr Authers points out, it follows that if you had placed your money on deflationary plays, you'd have had a happy time in 2015 : Short industrial and precious metals, long European government bonds, short China (from June, at least !), and short US inflation breakevens. **

 ** NOTE : We had a look at these the other day  --  Inflation breakevens : yield on US Treasury Note/Bond MINUS the yield on Treasury Inflation  Protected Security (TIPS) of same maturity, giving the MARKET'S view of inflation over that period.

It would be difficult to overestimate the importance of inflation considerations. Take currency markets, for example : largely by virtue of differing inflation expectations in the US to elsewhere leading to diverging interest rate policy, the US dollar has stormed ahead with profound implications for investors. The FTSE All-World equity index has fallen 1.55% year-to-date in dollar terms but is showing a return of 12.1% in euros  --  incidentally, it's gained 46.3% in Brazilian Real terms but that's something of a special case.

The belief that current trends will continue into 2016 is predicated on the assumption that deflation, or at least a lack of inflation, will also continue. On the face of it, there doesn't seem to be any immediate sign of upward price pressure. OPEC meet tomorrow and the general consensus is that there is little hope of any constructive agreement to boost oil prices, such an important factor for inflation. But that may very well not be the case when they meet again in 2016. More to the point, headline inflation numbers are calculated on a year-on-year basis, which means that the huge falls in oil and other commodities will soon fall out of the equation  --  a factor not fully priced into the markets.

The point is that whilst it's very possible that we'll see a continued lack of inflationary pressure, the real danger (because it's less expected) is that it will reappear when we're not prepared for it. How best to insure against it ? Sadly that traditional inflation hedge, gold, seems to have lost its lustre. The (rather cautious) suggestion here is to buy those US inflation breakevens , i.e. Buy inflation-proof TIPS / Sell normal Treasuries.

Interestingly, on the very same page in the FT and seemingly without reference to each other, the capital markets column tells us how Goldman Sachs, JPMorgan, Morgan Stanley, UBS, RBC, SocGen, and BNP Paribas all believe that the prospect of inflation in 2016 has been underestimated, and that they would recommend buying inflation-proofed government debt outright . So perhaps it's not so unexpected after all, and traders may have to be ready to re-examine some long-held assumptions.